The Treasury market faces a key test over the next three days as dealers try to place $38 billion of new notes and bonds due to be auctioned at the quarterly refunding.

Traders and analysts were cautious yesterday, citing fears that the bond market's rally may be almost over.

And there are other problems plaguing the market, especially at the long end, including the possibility of federal tax cuts and recent Japanese selling of Strip securities.

The refunding auctions include today's $14 billion of three-year notes today, tomorrow's $12 billion of 10-year notes, and Thursday's $12 billion of 30-year bills.

Kathleen Stephansen, a senior economist at Donaldson, Lufkin & Jenrette Securities, said the state of the economy would be a key factor.

"One of the issues in this particular refunding is to what extent people will be convinced we're heading for a double dip, as opposed to a sustained, albeit weak recovery," she said.

Ms. stephansen is expecting the latter and is skeptical about the upside potential at the long end of the market.

"Once you get through 7 3/4% [on the long bond], you have to seriously rethink how you want to play your portfolio," she said. "Given the kind of fiscal policy you have, and also the inflationary outlook, it's hard to justify a long bond below 8% being permanent."

Treasury Market Yields

Prev. Prev.

Monday Week Week

3-Month Bill 4.95 5.11 5.14

6-Month-Bill 4.95 5.24 5.29

1-Year Bill 4.99 5.31 5.33

2-Year Note 5.62 5.93 5.93

3-Year Note 5.91 6.19 6.19

4-Year Note 6.05 6.34 6.36

5-Year Note 6.72 6.91 6.86

7-Year Note 7.15 7.32 7.22

10-Year Note 7.48 7.63 7.46

15-Year Bond 7.99 7.83 7.72

30-Year Bond 7.94 8.02 7.83

Source: Cantor, Fitzgerald/Telerate

Traders said the short end of the market is still being supported by the view that the economy is weak and will require further Fed easing to continue its recovery.

The Federal Reserve left monetary policy unchanged yesterday, but there is still a possibility it could ease the discount rate this morning before the quarterly refunding auctions begin.

The head of a trading desk said the short end might rally on a discount rate cut, but the outcome of this week's three refunding auctions would likely not be affected. He expects an "okay" three-year sale, a lackluster 10-year sale, and a miserable 30-year auction.

"The market's probably fully priced, and the foreign investment demand is weak," the official said. "I think the Street is going to be cautious."

One sign of that caution can be seen at the short end, where the spread between actively traded securities and off-the-run issues is widening.

"It's an early warning system," a government note trader said. "People perceive we're getting closer to the end of the rally, and they want to be in the active issues."

Since the active issues are more frequently traded, it would be easier to sell them in the event that prices began to fall, traders said.

The note trader added that the market-s discount-rate vigil might dampen bidding at the three-year sale.

Participants have been reluctant to prepare for the auction by setting up short positions, and that will make them less aggressive bidders at the three-year action, he said.

The Treasury's recent attempt to open up the bidding process is not execpted to have much effect on the refunding auctions.

The rule changes, which take effect beginning with today's three-year sale, allow all registered broker-dealers to bid for their customers at Treasury auctions. Previously, only primary dealers and depository institutions were able to bid for customers.

Another change increases the limit on non-competitive bids to $5 million from $1 million.

Analysts said brokers would probably not rush to place customers' orders at the auctions, since they lack experience in bidding.

Some felt the change in the non-competitive limit might have more impact.

"The smaller buyer may opt for the noncomp route to be assured of getting exactly what he wants at the average price, as the Treasury always fills noncomps first," said Joseph Plocek, an economist at McCarthy, Crisanti & Maffei Inc.

Traders seemed more worried about the fact that this is the first refunding to be bid without Salomon's full participation.

They said Salomon's absence, as well as the decrease in communication between dealers that has occurred since Salomon's bidding transgressions were revealed, could add to the uncertainty and result in sloppier auctions.

After Salomon revealed in August that it had submitted illegal bids at a number of Treasury auctions, the government barred the firm from bidding for customers. Salomon can still bid for its own account at auctions.

Long-term Treasuries ended lower yesterday after more reports of Japanese selling put pressure on bond prices.

The 30-year bond closed more than 1/8 point lower; where it yielded 7.94%.

Long Bond Drifts Lower

The long bond had been down more than 1/2 point at midday, but some buyers emerged at the lows.

As prices improved, other investors decided to cover short positions, a note trader said. "It started to feed on itself."

Strip selling has been a persistent problem in recent weeks, but one participant questioned how much the Japanese could have sold yesterday since their markets were closed for a holiday.

Treasury prices showed little reaction when the Fed let another opportunity to cut the discount rate pass by.

The fed did intervene at Fed time with $2.0 billion of customer repurchase agreements. Analysts said the addition of reserves had no policy significance, but confirmed the new funds target is 5%.

The weekly auction of $20.8 billion bills went well. The 3-month bills came at an average rate of 4.74% and the 6-month was sold at an average of 4.52%.

The widespread expectations for a Fed easing make bills attractive, and some participants sold short-term notes to buy bills, a bill trader said.

The December bond future contrace closed 7/32 lower at 99 11/32.

In the cash market, the 30-year 8 1/8% bond was 3/16 lower, at 101 28/32-102, to yield 7.94%.

The 7 7/8% 10-year note fell 1/8, to 102 16/32-102 20/32, to yield 7.80%.

The three-year 6 7/8% note was unchanged, at 102 11/32-102 13/32, to yield 5.91%.

In when-issued trading, the 30-year bond to be sold Thursday was bid at 7.92%, the 10-year note to be sold tomorrow was quoted at 7.47%, and the three-year to be auctioned today stood at 5.95%.

Rates on Treasury bills were mixed, with the tree-month bill down three basis points at 4.73%, the six-month bill unchanged at 4.78%, and the year bill one basis point lower at 4.76%.

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